HFT off the hook as cause of instability

There is so far no direct evidence high-frequency trading has increased volatility in the financial markets, according to working papers released by a UK government think tank. However, certain types of electronic mechanisms can cause instability.

There is so far no direct evidence high-frequency trading (HFT) has increased volatility in the financial markets, according to working papers released by a UK government think tank. However, certain types of electronic mechanisms can cause instability.

The Foresight study was initiated by the UK's Department for Business, Innovation and Skills to explore the effects of computer-based trading (CBT) on the stability of financial markets both now and in the future.

In working papers released this week, the think tank said the use of self-reinforcing feedback loops, i.e. when a small change loops back on itself, triggering a bigger change, could lead to significant instability in specific circumstances.

Feedback loops triggered by risk management systems or driven by changes in market volume or volatility could snowball into destabilising markets, the think tank warned.

Other mechanisms that may lead to instability in markets dominated by CBT include nonlinear sensitivities to change – where small changes can have very big effects – and incomplete information – where some agents in the market have more, or more accurate, knowledge than others.

The think tank also blamed certain social behaviours for creating instability.

“A fourth cause of instability is social,” the working papers said. “[In] a process known as normalisation of deviance, unexpected and risky events come to be seen as ever more normal, until a disaster occurs.”

The think tank will continue investigating a range of other possible factors which can cause instability in the markets.

Headed by professor Sir John Beddington, government chief scientific adviser, the Foresight study was announced in November 2010.

The project – entitled ”The future of computer trading in financial markets' – is intended to influence future government policy and is expected to continue its investigation for a further 12 months.

Public concern over automated trading grew last year after the ”flash crash' of 6 May, in which a broker algorithm triggered a temporary US$1 trillion crash in the value of the US stock market.